“[T]he work of protecting financial stability—of making sure the financial system can provide credit and other critical services in bad times as well as good—is far from complete.” Hutchins Center-Chicago Booth Task Force on Financial Stability Report, June 2021, page 6.
Thanks to unprecedented interventions by central banks and fiscal authorities, the pandemic-induced financial strains of March-April 2020 are now well behind us. Like the plunge in output and employment, COVID’s impact on financial markets was the deepest and broadest crisis since WWII, but it also was remarkably brief—lasting just two months in the United States.
Unfortunately, as a consequence of the interventions necessary to stabilize the financial system, market participants now count on government backstops to insure them against the fallout from future disturbances. In the United States, for example, the Fed’s massive support for both intermediaries and bond markets raises expectations of an unlimited Fed rescue whenever even modest disturbances arise (see our contemporaneous discussion here).
Naturally, central banks should be prepared to combat extreme shocks that threaten financial stability. However, to limit excessive reliance on the Fed, we need to ensure that financial institutions can continue to operate smoothly on their own even in bad times. This means redesigning parts of the financial architecture. While market participants have a major role to play, it is authorities who need to address externalities—spillover effects—and to improve incentives for the private sector to maintain the liquidity of markets and access to short-term funding in times of moderate stress.
With the pandemic-induced disruptions still fresh in memory, this is the perfect time to identify deficiencies and implement reforms aimed at improving the resilience of the financial system. Fortunately, the June 2021 Report of the Hutchins Center-Chicago Booth Task Force on Financial Stability (H-B) addresses all the key challenges, laying out a broad agenda for U.S. financial reform. In addition, we have the July 2021 G-30 Report that provides detailed proposals for reforming the U.S. Treasury market.
In this post, we discuss these reform proposals, highlighting areas where we strongly agree and believe that implementation is urgent. In particular, we emphasize the benefits that would come from changes in the Treasury market (cash and repo), in the central counterparties (CCPs) that have become the most critical links in the global financial system, and in open-end mutual funds holding illiquid assets. We also highlight the governance proposals in the H-B Report. In a few cases, our preferred reforms differ from those proposed in the reports. But the differences typically are matters of emphasis or detail, not of the general approach. Put differently, full implementation of the agendas set out in the H-B and G-30 reports would make the U.S. financial system far safer than it is today.
Let’s start by noting some broad aspects of the H-B approach. First, the authors presume that financial markets and institutions usually work well. As a result, they focus explicitly on the externalities that can be sources of market failure. These externalities arise from legacy market or institutional design (that may no longer be fit for purpose) or from the unintended consequences of existing regulation. Second, they seek the lowest-cost (most efficient) remedies to address these externalities. Frequently, their preferred reforms involve mechanisms (such as improved transparency) to enhance market discipline—say, by fostering better management of short-term funding needs and counterparty risk. Third, the H-B authors understand that technological change and regulatory arbitrage will cause the financial system to change in unforeseen ways, so regulators need tools both to anticipate and address evolving threats to financial stability. Finally, they recognize that preserving global stability requires coordination among the various authorities both domestically and internationally. This presents an especially big challenge in the United States, where the regulatory framework is uniquely balkanized (see our earlier post).
We strongly support this approach. We also share the broad H-B assessment that, after more than a decade of banking reforms, the greatest risks to U.S. financial stability are now in the nonbank sector. For decades, growth in nonbank intermediation has sharply exceeded that of banking intermediation (see chart). Since 1980, bank funding to the U.S. private nonfinancial sector (shaded in gray) stagnated at about 50% of GDP, while nonbank funding (red) rose by from 46% to 112% of GDP. Moreover, U.S. public finance (blue), which is largely intermediated through markets rather than banks, surged by more than 85 percentage points of GDP. As a result, bank financing of the private nonfinancial sector now reflects a mere 32% of total private nonfinancial credit and probably less than 20% of total credit.
United States: Credit to the nonfinancial private sector (banks vs. nonbanks) plus credit to general government (Percent of GDP), 1970-1Q 2021
Source: BIS.
In what follows, we highlight the H-B reform proposals in four areas: (1) the Treasury markets; (2) CCPs; (3) open-end funds; and (4) governance of the U.S. regulatory and supervisory system. (Because the proposals are highly detailed, non-specialists may prefer to skip to the “Bottom line” below.)
Treasury market reform. As the H-B and G-30 reports both emphasize, a dysfunctional Treasury market is a catastrophe for the global financial system. U.S. Treasurys are the safest and most liquid of U.S. dollar denominated securities, and their pricing is the benchmark for the pricing of all other financial instruments. For Treasurys to serve their critical hedging function, the market must always operate smoothly, regardless of conditions elsewhere. That was certainly not the case in March 2020: private market participants were unable to absorb the Treasurys others were trying to sell during the COVID scramble for cash (see our earlier post). Only massive Fed purchases—over $1.2 trillion in a mere five weeks—restored healthy market function.
How can we avoid a repeat of this episode? For the most part, the H-B and G-30 remedies are aligned. Perhaps the most important recommendation is for the creation of a Fed standing repurchase facility (SRF) for Treasurys and other fully federally guaranteed securities with broad access, and at a penalty rate that limits use in good times. We view this approach as a modern implementation of Bagehot’s crisis rule: “lend freely to solvent but illiquid firms against good collateral at a high rate of interest” (see Tucker, page 16). The existence of such a reliable funding mechanism should reduce the incentive of intermediaries and investment funds to dump Treasurys in a crisis.
It is important to underscore that this proposal differs from the narrow SRF that the Federal Reserve established in July 2021. (The Fed also renewed the special repo facility for foreign official institutions that is a complement to the dollar liquidity swap facility.) Converting this new facility into what the two reports recommend requires significant changes. First, there is access. The current SRF is available only to primary dealers and will eventually provide access to “additional depositories.” Critically, some of the most active participants in the Treasury market—including asset managers, principal trading firms, and some broker-dealers—do not have access. A broad repo facility would allow many of these firms to participate. Second, to limit moral hazard, the H-B Report calls for imposing an advance fee on nonbanks (that otherwise do not have access to the Federal Reserve) to obtain the crisis liquidity insurance afforded by the SRF. Finally, to create certainty and avoid fire sales in a crisis, the facility should establish haircuts on government collateral that are adjusted only during normal times—that is, remain unchanged during a crisis.
Both reports also highlight the need to avoid unintended consequences from bank regulation. For example, when leverage ratio requirements (which treat risky and riskless instruments identically) bind, it is costly for banks make markets in Treasuries. To avoid this distortion while still ensuring that banks are adequately capitalized, regulators may need to adjust “risk-weighted” capital requirements so that (as originally intended) banks do not expect the “backup” leverage ratio requirements to bind (especially in a crisis).
Both reports also discuss the potential advantages of mandating central clearing for those parts of the Treasury market that currently clear on a bilateral basis (see our earlier post). This has the obvious benefit that multilateral netting reduces liquidity needs, especially when the market is under stress. The H-B report calls for further study in this area, while the G-30 report recommends a mandate for central clearing for all Treasury repo trades and for those Treasury trades on interdealer platforms that currently clear through a dealer. Subject to Fed prudential oversight, the G-30 report also calls for a nonbank CCP that clears Treasury transactions to have access to the SRF.
Both reports contain additional proposals that would help make the Treasury market more efficient and resilient. These include broader data collection (especially in the repo market) and trade disclosure (for example, by expanding FINRA’s TRACE reporting system), as well as (in the G-30 report) a review of the prudential safeguards for nonbank dealers in Treasurys and repo.
Central counterparties. As a direct consequence of reforms adopted in the aftermath of the Great Financial Crisis (GFC) of 2007-09, CCPs are now the most central and critical nodes in the global financial system (see, for example, here and here). Relative to the complexity and opaqueness of bilateral agreements that dominated derivatives trading prior to the GFC, CCPs offer great advantages. They reduce counterparty risk, facilitate monitoring of risk concentrations, increase market depth, and encourage application of consistent and transparent margin requirements. In combination, these characteristics can significantly reduce the likelihood of a scramble for cash in bad times. But CCPs also concentrate risks in institutions for which there is no short-run substitute. Given their essential public-utility role, market participants are sure to expect government support in a crisis.
The H-B Report elegantly highlights the externalities in the world of CCPs—especially for those in derivative markets, where CCPs bear long-term counterparty risks (say, for the life of an interest rate swap) in the event of a clearing member default, and where leverage and valuation problems abound. Here are the key CCP externalities that H-B identify:
Stress-driven margin calls that can trigger fire sales
Actions by privately owned CCPs can force losses onto clearing members
Spillovers across CCPs (and jurisdictions) can be transmitted through common clearing members
CCP failures (unrelated to clearing members) can undermine continuity of operations
H-B’s compelling solutions include: robust collateral requirements, adequate skin in the game for for-profit CCPs, a minimum standard for default funds, broader stress testing and disclosure to ensure adequate resources for continuity of operations, pre-defined loss allocation plans to limit unforeseeable risks for clearing members, greater official oversight of CCP systemic risks, access to the lender of last resort for systemic CCPs outside the United States, and improved cross-border resolution planning. (In this regard, we note a recent working paper by Paddrik and Young from the Office of Financial Research that lays out a uniform standard for assessing the safety of CCPs and ensuring adequate default funds, as well as the CCP information requirements needed to implement it.)
Open-end Mutual Funds. Open-end funds holding illiquid instruments (such as corporate, municipal, or emerging market bonds, or real estate) promise daily liquidity that vastly exceeds the liquidity of their assets. In stress periods, the resulting first-mover advantage can trigger runs with consequences like those of a bank run (including fire sales and a credit crunch).
In previous posts, we discuss the systemic fragility arising from both open-ended mutual funds and money market funds (MMFs). For open-end funds, our preferred remedy is for regulators to call on asset managers to transform them into exchange-traded funds (ETFs) (see here and here). ETFs function like open-end funds when the markets for the assets they hold are liquid, and like closed-end funds (from which investors cannot run) when those markets are not liquid. This makes ETFs less runnable both in theory and practice. As for the reform of MMFs, there we believe that the system would be much safer if there were requirements for some mix of capital buffers, redemption limits (“minimum balance at risk”) and swing pricing (which imposes a withdrawal penalty scaled to the size of aggregate redemptions).
To reduce “extreme liquidity mismatches” in open-end funds and MMFs, H-B call for wide application of swing pricing. Where swing pricing is unworkable, H-B recommend addressing the liquidity mismatch directly, calling for the creation of a new class of funds (“between existing open- and closed-end funds”) that permit less-frequent redemption and longer payout periods.
Regulatory Architecture. From a long-run perspective, the most important of the H-B reform proposals address how to make the complex U.S. regulatory framework more effective at containing systemic threats. The authors’ two key premises are compelling. First, the perpetual evolution of the financial system eventually makes any static set of rules ineffective in preserving financial stability. Second, in light of the powerful past resistance to worthy efforts at streamlining the regulatory framework, it is pragmatic to seek limited modifications that motivate the various regulators to use the tools they already have, to improve their capacity to anticipate threats to financial stability, and to encourage greater coordination.
At the top of H-B’s list of proposed governance reforms is a set of changes that aim to increase the salience of financial stability as a goal for policymakers. First, Congress should make explicit the financial stability mandate of each agency that is a member of Financial Stability Oversight Council (FSOC). Second, each member of the FSOC should have an “Office of Financial Stability and Resilience” with an obligation to cooperate with their counterparts at the other agencies. Third, the FSOC Annual Report should serve as a coordination mechanism to compel each agency to look forward (and back) to anticipate (or recognize) developments that pose a risk to financial stability, including emerging gaps in both regulation and available information. Fourth, to make the FSOC’s most important legal power credible, a new Treasury undersecretary for financial stability would periodically present the case (for or against) designation of large nonbanks as systemic intermediaries or utilities under the Dodd-Frank Act. Finally, to elevate the importance of data gathering, H-B proposes transforming the FSOC’s support arm, the Office of Financial Research (OFR), into an independent “Comptroller for Data and Resilience.” They also would make the Comptroller a voting member of the FSOC member (in contrast to the current OFR Director’s nonvoting support role).
To their credit, the H-B authors conclude by addressing the critical counterfactual: had their modified regulatory architecture been in place, would it have reduced the required scale of official sector intervention in the spring of 2020? In our view, the Report argues persuasively that many of the 2020 challenges (including the deteriorating capacity in the Treasury market, the vulnerability of MMFs and open-end funds, and the potential contagion through CCPs) would have been identified well in advance as systemic fragilities. That is, a regulator with “the right set of tools, information and incentive” would have detected them and begun to address them, reducing the disruptions from the COVID shock. Going forward, H-B also argue that their regulatory adjustments would help address emerging challenges, including cyberthreats, common exposures through financial services vendors, elevated nonfinancial corporate debt, and climate risks.
Bottom line: We find it remarkable that there has still been so little regulatory response to the enormous increase of moral hazard created by the 2020 policy interventions. While there will always be healthy debate about the costs and benefits of using regulation to ensure financial stability, there should be little doubt that systemic disruptions will recur. Moreover, in the absence of reforms, the combination of technological change and regulatory arbitrage points to more frequent and larger disruptions. With the reform agenda so clearly laid out by the Hutchins-Booth and G-30 reports, we can only hope that policymakers will move forcefully and expeditiously – with or without Congressional action – to make the financial system more resilient.